Can the Euro Survive?

In December 1998 and January 1999, high-energy physicists in Russia created a superheavy element called ununquadium with a record 114 protons. It was an impressive technical achievement. Alas, ununquadium ("oon-oon-QUOD-ee-um") is too unstable to exist in nature. The force binding its nucleus together is overwhelmed by the force tearing it apart. The synthetic element has a half-life of just 2.6 seconds.

At the very moment that the physicists in Dubna, Russia, were birthing ununquadium, another group of scientists—dismal scientists—were smashing together the currencies of Western Europe to form a brand-new synthetic element known as the euro, which they proudly launched on Jan. 1, 1999. Less than a dozen years later, the euro is under serious strain. "European officials have squandered...confidence, and like toothpaste coming out of a tube, it is difficult to put it back in," writes Marc Chandler, global head of currency strategy at Brown Brothers Harriman. Some agonizing questions are being openly asked. What will it take to restore monetary stability in Europe? Is the euro, like ununquadium, simply too massive for the natural world? If so, how might it blow apart—and how much damage might it do in the process?

What's so concerning to European policymakers is that the conflagration keeps jumping over their firebreaks. Sovereign borrowing costs kept rising after the announcement on Sunday, Nov. 28, of a tentative €85 billion emergency loan package for Ireland. It's not even clear that the Irish legislature will agree to take the money on the terms offered. "The plan should have been announced in Lourdes because, short of a miracle, it is doomed to failure," says Jack O'Connor, head of SIPTU, Ireland's biggest union.

Back in 1999, at the euro's launch, hopes were high that Europe would cleanse itself of its warring past as efficiently as it dispensed with historic currencies like the peseta, franc, guilder, and deutsche mark. Speakers harked back to Winston Churchill, Britain's wartime Prime Minister, who in 1948 said: "We hope to see a Europe where men of every country will think of being a European as of belonging to their native land, and...wherever they go in this wide domain...will truly feel, 'Here I am at home.' " If anything, the opposite is occurring. The euro coin has become a millstone to many, and forced togetherness is reviving prejudices between nations.

Sovereign debt crises aren't new. Greece was in default on foreign debt for 90 of the years between 1826 and 1964, according to economists Carmen Reinhart and Kenneth Rogoff. What makes this crisis a threat to the euro's solidity is that the common currency is impeding member nations' ability to get back on their feet. Ordinarily when a nation like Greece or Ireland loses competitiveness, it gets it back by allowing its currency to depreciate—its exports automatically become cheaper to foreign customers while imports become more expensive, which discourages consumers from buying so many of them. Iceland regained competitiveness when its krona abruptly lost half its value in 2008. Since the euro zone's weaker members can't depreciate, the only way for them to regain competitiveness is to cut pay and benefits. That's "a very much more painful way to achieve real devaluations," Martin Feldstein, the Harvard University economist and former chief economic adviser to President Ronald Reagan, wrote in a June article in The Weekly Standard. (Feldstein, not incidentally, was warning about the euro's drawbacks in 1999, when many other economists were all smiles.)

It's been known for years—centuries, really—that monetary unions are hard to hold together. World War I killed the Scandinavian and Latin monetary unions, the latter of which included France, Belgium, Italy, Switzerland, Greece, and Bulgaria. As theorized by Robert A. Mundell, the Nobel Prize-winning economist at Columbia University, a monetary union can't survive without something very close to political union, including free mobility of labor to nations where jobs are more available, flexible wages, a tax system that transfers funds from the winners to the losers, and strict rules preventing members from running up big budget deficits. Members must feel that burdens are fairly shared: Ireland has infuriated the Germans by keeping its corporate income tax rate at 12.5 percent (Germany's is 30 percent) even while appealing for help. The euro's backers optimistically believed that the very yoke of the common currency would bring about the behavior the euro's continued existence depended upon. The euro was—as the English essayist Samuel Johnson said about second marriages—the triumph of hope over experience.

The euro zone's crisis may yet galvanize political leaders to tighten the links between their nations. "We may see a much faster move towards a de facto fiscal union," says Gary Jenkins, head of fixed income at London-based Evolution Securities. The euro stopped falling on Dec. 1 on a hint from European Central Bank President Jean-Claude Trichet that the bank might support endangered countries by buying more of their bonds. A more dramatic though less likely gambit would be to raise funds with a new "blue bond," whose payments would be guaranteed by all euro zone members collectively. Euro nations understand that a breakup of the zone would have serious repercussions. "No one gains," Carl Weinberg, chief economist of High Frequency Economics in Valhalla, N.Y., wrote in a Nov. 29 e-mail. "Thousands of jobs in Germany's export sector would be lost" if a euro breakup resulted in a high-priced new deutsche mark, Weinberg wrote, while "the southern zone would lose access to the finances and the financial standing of their monetary link to the richer nations."

But as European credit markets go haywire, it's no longer possible to rule out a euro zone breakup of some kind. And it would be hard to stop at just Greece or just Ireland. "Once you've established the principle that a country can leave, you've planted the idea that others can leave," says Mark Cliffe, chief economist of ING (ING), the Dutch financial giant. "Frankly, I can imagine just about anything happening here."

If the euro zone were to break up, it would make sense for member nations to regroup in more defensible configurations—ones more nearly resembling the optimal currency areas described by Columbia's Mundell. To stop the market terror before it engulfs all of the euro zone, the fiscally strongest nations should gather behind an impregnable "cordon sanitaire," argues Simon Johnson, the former chief economist of the International Monetary Fund, who is a professor at Massachusetts Institute of Technology and a Bloomberg News columnist. As Johnson sees it, those strong nations would trust each other enough to promise one another unlimited financial support if any of them ran into trouble, which would stop the bond market vigilantes cold. In that group he puts Germany, Austria, the Netherlands, Finland, Slovakia, Slovenia, Luxembourg, and tiny Malta.

The scary thing about Johnson's cordon sanitaire is that it would leave France, Italy, Spain, Belgium, Portugal, Ireland, Greece, and Cyprus on the outside, unshielded from market forces. At least a couple of the weaker shunned nations would be likely to default. In the long run, though, it could be a blessing for them to be spared from monetary and fiscal policies that just don't suit them and debts that are, frankly, unpayable. Like serial defaulter Argentina, they would still find it possible to borrow money, albeit at a higher rate. And with depreciated national currencies, they would be able to match their exports to their imports.

The biggest downside of such a scenario would be the death of the dream of a united Europe. It appears, though, that Europe still isn't ready for a full union. As in the nucleus of the elusive ununquadium atom, the forces of repulsion remain stronger than the forces of attraction. It might be wiser to acknowledge that reality than to sacrifice a generation of indebted Europeans to an impossible ideal.